3 common questions about mutual funds and taxes

When you’re researching mutual funds for your portfolio, it’s important to look at several factors, including the fund’s investment objective, track record, and risk level. But what about taxes? How much should they impact your decision?

First, it depends on what type of account you have. If you’re buying mutual funds for a tax-advantaged college savings account or retirement account such as an IRA or 401(k), it’s typically not an issue . For these accounts, you only pay taxes when pre-tax contributions or earnings are withdrawn (with some relatively rare exceptions).

But for investments held in other types of accounts, it can be a different story. Mutual fund shareholders may incur taxes on any dividends and interest income distributed by the fund, and also on any distributed or undistributed capital gains, which result from the mutual fund manager selling certain fund assets for a profit.

Why do fund managers sell assets? Securities are usually sold in the normal course of pursuing the fund’s investing strategy. But managers can also be forced to sell securities in order to cover outflows. That means raising cash to pay shareholders who decide to redeem their shares and take money out of the fund. Capital gains distributions for a given tax year typically happen in November or December, and they can impact you even if you did not redeem any fund shares yourself.

Let’s look at three common questions that investors ask when thinking about mutual funds and taxes.

No. As you probably know, short-term capital gains are generally taxed at higher rates than long-term capital gains (and sales of precious metals have their own tax treatment). Some mutual funds can use long-term investment strategies to minimize the impact of short-term capital gains on the fund’s shareholders, compared to other funds that trade more frequently.

There’s a way to gauge if a fund is less likely to generate short-term gains: turnover. A fund’s turnover tells you roughly what percentage of its portfolio has changed over the past year. Lower turnover can help reduce the potential for the fund to realize short-term capital gains.

Mutual funds that seek to track major indexes—like the S&P 500—tend to have low turnover since the securities they own aren’t changed frequently. In contrast, funds managed by portfolio managers who choose securities for the fund may have varying degrees of turnover.

The bottom line: Turnover and tax efficiency tend to move in opposite directions: Generally, the lower the fund’s turnover, the higher potential tax efficiency, meaning investors give up less of their gains to taxes.

Not necessarily. Whether or not the turnover in a fund is tax efficient really depends on how well the managers are able to strategically offset capital gains by selling securities with unrealized losses. This is called tax-loss harvesting.

Many investment professionals also point out that while taxes are a consideration in investing, they shouldn’t be the driving factor. Investors should focus on after-tax results, not just taxes. If an actively managed mutual fund has better results, the amount investors keep after taxes may still be greater than with an index fund.

The bottom line: Don’t make investment decisions based solely on tax concerns. After-tax returns—not to mention other factors such as diversification, your time horizon, and expense ratios—matter just as much or more.

Generally, yes, but not in every way. Mutual funds and ETFs are on equal footing with many common taxable events.

ETFs are able to minimize the capital gains they incur through the process they use to create and redeem shares that are traded in the market. This reduces the capital gains distributions that the ETF would otherwise need to make. Due to the way they are structured, mutual funds cannot use the same mechanism to avoid making capital gains distributions to shareholders.

That said, an ETF shareholder will incur capital gains when they sell their shares. That’s also true for someone who sells mutual fund shares, but if they are invested in the same portfolio of securities, they may have a somewhat lower tax bill when they sell. That’s because, unlike the ETF shareholder, they would have previously paid some tax on reinvested capital gains distributions. Given the same tax rates, it’s better to pay taxes later (the ETF shareholder) rather than earlier (the mutual fund shareholder), but the difference in total taxes paid may not be as large as some investors assume.

Finally, when it comes to distributions of dividends and interest, the tax consequences are the same for both ETFs and mutual funds.

The bottom line: Due to their structure, ETFs do have a potential tax advantage with capital gains distributions, but that advantage does not extend to dividends and interest payments.

For additional tax-related information, visit our Tax Center—or speak with an E*TRADE Financial Consultant at 877-800-1208.